On Libra and DC/EP（中）

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Ⅰ.3.3. Complement and Substitute Effects

In many use cases, the token model can substitute for the account model. The most prominent example is the comparison between stable coin and third-party payment (Figure 3).

Figure 3: Stable Coin and Third-party Payment

For stable coin, I use USDC as a representative. USDC is a US dollar stable coin. It is backed 1:1 by US dollar reserve. Any institution that follows the USDC agreement and meets compliance requirements can become a USDC issuer. USDC issuers must keep US dollar reserve provided by users in a bank covered by the FDIC. USDC transactions between users are essentially token transactions inside blockchain. When users redeem USDC, USDC issuers destroy a number of USDC and transfer an equivalent amount of US dollar from the custodian bank to users’ deposit accounts.

In third-party payment, after users refill, third-party payment institutions deposit users’ funds into custodian accounts with banks[]and credit users’ third-party payment accounts. The balance of third-party payment accounts is essentially an IOU (i.e. I owe you). Transactions between users of the same third-party payment institution only involve adjustment of their third-party payment accounts (i.e. IOU transactions) and do not impact custodian accounts in banks. When users withdraw, third-party payment institutions transfer money from custodian accounts to users’ personal bank accounts.

Therefore, stable coin and third-party payment share similar structures, except that the former follows the token model and the latter follows the account model.

In other use cases, there is a complementary relationship between the token model and the account model. For example, most USDC transactions take place on crypto exchanges. Users send USDC to crypto exchanges’ addresses and crypto exchanges credit users’ accounts with them. The balance of users’ accounts with crypto exchanges is an IOU too. USDC trades on crypto exchanges are IOU trades. Being not subject to blockchain’s performance bottleneck, IOU trades can be highly efficient.

Ⅰ.3.4. Token Model and Fiat Money

Table 3 classifies the application of the token model in the field of fiat money. My classification is based on two dimensions. The first dimension is whether issuers are central banks or private institutions (but they all follow the 3 rules introduced in Section Ⅰ.2). The second dimension is whether target users are wholesale or retail.

Table 3: Fiat Money and the Token Model

Ⅱ. Libra

There has been lots of discussion about Libra in the past 6 months. In this part, I will focus on the points that are most relevant to this article.

Libra’s operation mechanisms are:

Economic value: Libra is a synthetic currency unit based on a basket of currencies (USD 50%, EUR 18%, JPY 14%, GBP 11% and SGD 7%). Libra price is linked to the weighted average exchange rate of its component. Although Libra does not anchor to any single currency, it will still exhibit low volatility, low inflation, universal acceptance and fungibility.
Reserve assets: Libra is 100% backed by fiat reserve. Fiat reserve will be held by investment-grade custodians around the world and invested in bank deposits and short-term government bonds. Investment income of fiat reserve will be used to cover system operating costs, ensuring low transaction fees, and pay dividends to early investors (i.e. "Libra Association"). Libra users do not share investment income of fiat reserve.
Issuance and price stabilization mechanisms: Libra Association will select a certain number of authorized dealers such as compliant banks and payment institutions. Authorized dealers can trade directly with fiat reserve.
Underlying technology: Libra uses a consortium blockchain. Libra plans to recruit 100 verification nodes and support 1000 transactions per second. 100 verification nodes form Libra Association, which is registered as a non-profit organization in Geneva, Switzerland.
Governance structure: The governing body of Libra Association is its council, which is composed of member representatives with each verification node assigning a representative. All decisions of Libra Association will be made through the council, and major policy or technical decisions require more than two-thirds of the members to vote.

I have the following comments on Libra:

Libra is a synthetic currency unit based on a currency basket. Like the IMF’s SDR (special drawing rights), Libra is a super-sovereign currency. Since Libra is 100% backed by fiat reserve, the only way to issue more Libra is to deposit more fiat assets into its reserve. At the issuance stage, it is fair to say that there is no money creation. In the future, will there be Libra deposits and loans and therefore Libra M2? Although Facebook says it has no intention to do so, this possibility can be supported by current technologies and can’t be ruled out. If this happens, there will probably be money creation.
Libra will certainly be a store of value. Currently, other types of stable coin are mainly used on crypto exchanges rather than in people’s everyday life. Will Libra be an effective payment tool (i.e. medium of exchange and unit of account)? It depends on how Facebook and its alliance promote the use of Libra in the real world. I am pretty sure they have enough resources to do so. However, at present, there are no goods or services denominated in Libra and money has a strong network effect. It will take lots of time and efforts for Libra to be widely adopted in retail use. One limitation that can’t be ignored is the performance of Libra consortium chain.
Libra can promote financial inclusion. To own and use Libra, users only need to install Calibra wallets on their mobile phones. This is much easier than to open bank accounts. However, the accessibility of Libra also leads to concerns of currency substitution: In countries with unstable political and economic situations, will Libra “crowd out” local currencies? Libra’s possible impacts on currency sovereignty has made it highly controversial around the world.
Libra Association has not disclosed how it plans to manage Libra’s fiat reserve. What will happen if Libra’s fiat reserve adopts an aggressive investment strategy to pursue higher returns? For example, to invest a large percentage of fiat reserve in long term, high risk, and illiquid assets. If there is a large redemption of Libra, there may not be enough liquid assets in fiat reserve to meet redemption. Libra may be forced to liquidate part of fiat reserve in a “fire sale” approach. This would further push down asset value and worsen Libra’s liquidity profile or even its solvency. Since Libra has no lender-of-last-resort support from any central bank, a run on Libra will cause systemic risk. Therefore, how Libra manages its fiat reserve should be strictly regulated.
Libra Association has not disclosed how it plans to rebalance Libra’s currency basket, either. The actual currency composition of Libra’s fiat reserve will deviate from that of its currency basket from time to time. This will lead to complicated arbitrage between Libra and its components and cause the value of Libra to fluctuate.
Libra’s fiat reserve will be kept in custodian banks with investment grades. However, investment grades do not guarantee default free. What will happen to Libra if one of its custodian banks becomes bankrupt? I think Libra’s custodian banks should meet strict regulatory requirements. If Libra keeps part of its fiat reserve in one or more central banks, Libra will become a kind of synthetic CBDC. I will return to this point in Part Ⅲ.

Libra will be used cross-border and cross different currencies and financial institutions. It will have complicated impacts on cross-border capital flows and should be regulated accordingly.

注释
[1] In China, this is the case before the reform of “direct link disconnected”.